Options for bargain hunters

08/05/21
  • Pinterest dropped 18% after last week’s earnings
  • Options volatility has since dropped as stock has consolidated
  • Lower volatility tends to make options cheaper

Long-term investors sometimes try to boost their returns by selling out-of-the-money (OTM) call options on stocks they hold—the “covered call” strategy. The basic idea is to collect premium by shorting call options with strike prices that are far enough above the market that they won’t get exercised.

The reason it’s referred to as a “covered” call is that if the options are, in fact, exercised, you own the shares you’ll be forced to sell (at a profit, of course). Overall, it’s a conservative way to try to enhance long-term investment returns. The primary risk is that, if exercised, you’d have to buy back your shares at a higher price than you sold them.

Options traders have to account for additional moving parts—most importantly, volatility.

In a way, the basic logic is similar to that of the vertical call spread, which combines long and short options with the same expiration but different strike prices. For example, the bullish vertical call spread consists of a long call (typically with a strike price near the current stock price) and a higher-strike (OTM) short call. The spread’s long call is equivalent to the investor’s long stock position, while the short call again plays the role of representing the price level at which the trader is willing to sell the stock—in other words, the trade’s maximum potential profit.

The difference between the covered call and the vertical call spread is mostly a matter of time horizon and scale: The investor is typically looking to hold the stock position for many months or (more likely) years in the hopes of capturing indefinite long-term gains, while the spread trader is usually interested in a more-defined, shorter-term up move.

Unlike long-term stock investors, though, options traders have a few more moving parts to consider—perhaps most importantly, volatility. To get an idea of how this can factor into a vertical spread, let’s look at Pinterest (PINS), which yesterday consolidated for a third day after last Friday’s 18% earnings sell-off:

Chart 1: Pinterest (PINS), 5/6/21–8/4/21. Pinterest (PINS) price chart. IV down after earnings sell-off.

Source: Power E*TRADE (For illustrative purposes. Not a recommendation.)


While a longer-term PINS bull may simply look at this as an opportunity to scoop up shares at a relative low point, for the sake of argument, let’s say a trader was interested only in the possibility of a nearer-term, more-limited rebound—say, back to where the stock was trading right before earnings (around $75).

The bottom of the chart shows PINS’ implied volatility (IV) was below where it was immediately before the earnings announcement, and below its historical volatility (HV)—two indications that IV was leaning toward the relatively low side rather than the relatively high side. That means options premiums were less likely to be running hot, which is a good thing for buyers. The following chart supports that basic picture, showing PINS’ IV (solid line) was below its 30-day average (dashed line) for all expirations through September:

Chart 2: Pinterest (PINS) implied volatility profile, 8/4/21. IV below 30-day average.

Source: Power E*TRADE (For illustrative purposes. Not a recommendation.)


Again, drawing on the parallel to the covered call strategy, while the bullish vertical spread contains both long and short options, it’s designed to profit mostly from an increase in the long call’s value if the underlying stock rallies. The short call essentially lowers the cost of getting this long-side exposure by bringing in some premium (while also offsetting some of the long call’s time decay, as well as limiting the trade’s potential profit and maximum risk). So, the cheaper the long call (via lower IV), the cheaper the “shares” the trader is getting.

Trading and investing are definitely different animals, but sometimes they leave similar tracks. Sometimes you can gain insights into one discipline by understanding the principles of the other.

Today’s numbers include (all times ET): Challenger Job-Cut Report (7:30 a.m.), International Trade in Goods and Services (8:30 a.m.), Weekly Jobless Claims (8:30 a.m.).

Today’s earnings include: Alarm.com (ALRM), Beyond Meat (BYND), Carvana (CVNA), Kellogg (K), Dropbox (DBX), Yeti (YETI), Yelp (YELP), Square (SQ), Regeneron (REGN).

Today’s IPOs include: Cadre Holdings (CDRE), Weber (WEBR), European Wax Center (EWCZ), WCG Clinical (WCGC).

 

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